Value investors like Benjamin Graham and David Dodd invented the phrase margin of safety. Those value investing masters classified a stock’s margin of safety as the difference between a stock’s market price and its true value. If you want to buy stocks like Buffett, find companies that are selling at a discount to their true value. This is number 9 on our list of the 10 Things To Look For When Buying A Stock.
How do you find a stock’s true value?
A stock’s true value is based on a number of factors including current earnings, cash flows, earnings potential, P/E ratio, and more. Investing in stocks with a margin of safety gives an investor the ability to survive market corrections and short sales. If a stock has no margin of safety then you allow yourself no room for error. You could lose a sizeable sum by chasing a stock trading over its true value.
Every investor should aim to only buy shares of a stock when it is trading below its true intrinsic value. The price that you pay for an investment matters because it determines whether you made a wise investment decision or a poor one
Why price matters?
Two investors can own the exact same stock and it could be a great investment for one investor and a terrible investment for the other one. For example, let’s say you bought shares of Apple at $100 in 2008. The stock could be one of your greatest investing wins since shares are now valued at well over $300.00.
Conversely, let’s say you bought shares of Apple a few weeks ago when it was trading above $320. The stock is currently trading below where you bought it at and you are actually in the red on your investment. Your purchase of Apple has not been such a great deal.
Where can you find value stocks?
Look for companies that participate in industries that are often overlooked and neglected by Wall Street. Wall Street brokerage firms love tech stocks because they participate in an exciting industry. The same firms may not pay as much attention to a garbage company, paper producer, or a bottle maker. You have the advantage over these firms in industries like these.
Look for companies with low Price to Earnings ratios, low Price to Book Value ratios, and a low Price to Sales number.